Method of Accounting: The Importance of a Company's First Filing of its Tax Return
First of all, the truth about professional tax software is that it automatically selects the cash method of accounting for all business returns that you file.
However, the single most important election you make on the initial tax return is the method of accounting. Cash is most commonly used because on the taxpayer’s books, they will have accounts receivable, and the tax preparer will justify the use of cash because they won’t have to claim as income money the company never saw.
This effectively lowers the taxable income because the receivables aren’t taken into account. If for some reason, down the road, it becomes more tax advantageous to use another method of accounting, you have to File Form 3115 and get approval from the IRS to change the method.
If you think about it, by filing Form 3115 with the IRS to change the method of accounting you are basically telling the IRS that you have never counted income and expenses correctly. And the change you are requesting will clearly reflect the income and expenses.
I don’t know about you, but my thoughts of filing this form is that you are drawing attention to every previously filed tax return because income and expense were never reflected in the correct way, and the IRS may decide to audit those previous years to see what was wrong with them.
Before I file the first tax return for a company, I will have a conversation with the business owner about their business, where I ask them about their one-year, five-year, and ten-year plans. Most clients use an accounting system like QuickBooks, and all they will keep track of are their invoices in the system. Rarely will a company keep track of accounts payable. Therefore, selecting cash just based on these statements is borderline malpractice.
Under another method such as accrual, income is recognized when the company has a right to the income, which is where the receivables will come in. But one thing that is lost is under the accrual method, you can match expenses to income, meaning that you can accrue certain expenses that the company is contractually obligated to pay, based on the income that is being reported. These expenses include rent, salaries, employee benefits, payments to subcontractors, and anything else that matches the income never received.
In later years, the accrual method can become a powerful tax planning tool, in the sense that the matching of expenses to the income may produce higher expenses than accrued income, naturally creating a tax deduction. That is why it is important to have these conversations with the business owners before the first return is filed.
The cash method is pretty cut and dry, you remove receivables and payables, and you have taxable income, where the accrual method allows you to play a legal game of accruing most expenses. With cash, there is basically no wiggle room when preparing the return.
A couple of words of note: When a company reaches a certain income threshold, they are required to use the accrual method without applying to take it. Further, selecting the cash method requires you, year after year, to convert to the cash method from an accrual-based statement. In my experience QuickBooks will print a cash or accrual basis financial statement. However, I have learned that when the program makes this conversion from accrual to cash, it is wrong, so I do all of my conversions by hand.
The final method of accounting that you can use is probably the least understood method. The hybrid method of accounting is used when you want to use the cash method of accounting for income and expense and the accrual method for inventory. This method would be used if the company has little or no receivables and payables but has inventory.
The calculation of inventory under the accrual method tends to overstate, per the return, cost of goods sold (COGS), while income and expenses are not reflected. It’s a win-win for certain companies.
The filing of the first company’s tax return is extremely important, because of the election of accounting method. One word of note, if there is a second company, with related shareholders, all companies MUST use the same method of accounting.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...